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Pointers towards a better pensions landscape

As pension arrangements around the world increasingly shift the onus for making provision in retirement to individuals, the savings industry faces a set of unfamiliar issues.

11/12/2014

As pension arrangements around the world increasingly shift the onus for making provision in retirement to individuals, the savings industry faces a set of unfamiliar issues. Whereas the management of defined benefits arrangements is fundamentally an investment challenge, the challenge in defined contribution (DC) is much more about emotion and psychology. In DC, sound investment principles are very likely to come into conflict with the messy real-world human biases and preferences that characterise individual savers.

So what should the industry do? Should it create answers that the customer wants or answers that the customer needs? We certainly think we need to be bold, remembering the comment often attributed to Henry Ford, developer of the first mass-market car, that ‘if I had asked people what they wanted, they would have said faster horses.’ This applies particularly to financial services where, perhaps more than elsewhere, people expect the experts to lead them down the right path. That said, trust in financial services is not in plentiful supply right now. Since the credit crunch, people need to have even greater confidence in the financial products they are being offered. Moreover, the deferred gratification inherent in pension provision is already a big hurdle to overcome with most would-be savers. Persuasion is therefore going to be crucial.

This article seeks to outline the sensible principles that can help guide us towards building solid foundations for retirement portfolios, blending – we hope – what people need with what they want.

Some prudent pension principlesProspects for an asset’s returns are mathematically dependent on its starting value, so price is where any saver must start. Sustainable wealth accumulation means at least two things: investing in assets when they are not expensive and then protecting them from the corrosive effects of long-term inflation. Success in the latter is to a large extent achieved by success in the former, but asset prices inevitably change. They are influenced by many things but – to take a DC example – an asset allocation glide-path is not among them. Indeed, such a static allocation can be harmful, as asset values are prone to periods of over– and undervaluation. So investing while being totally agnostic to the price paid can be harmful to retirement ambitions.

Just as a balanced diet is to be recommended for an individual’s well-being, a portfolio which seeks to harvest multiple return sources is preferable to one which relies on a single asset. Given that the prices of assets do not move in tandem (over most time periods), this should also help to make the ride less bumpy, a key part of persuasion.

However, diversification should be with purpose – an asset has a role in a portfolio only if it has return potential or insurance potential. So purposeful diversification is another ingredient we believe is crucial for savers, both before and particularly after retirement.

It is acknowledged that the central issue for most people is that they have not saved enough for retirement. Some will be persuaded to save more but, for many others, maintaining a growth component into retirement will be a necessary condition for an adequate pension. The principle of money-weighted returns means that having that growth when the portfolio is larger will have much more impact – so the size of the portfolio and the sequence of returns matters too1 (see more on this below).

Given the significant increases in life expectancy since 1960, most people will spend a large proportion of their lives as retirees (from 1970 to 2010 life expectancy globally has increased by about four hours every 24 hours2). This should permit them to run higher levels of investment risk in their portfolios into retirement.

The modelling carried out by Don Ezra and his colleagues at Russell Investments, the consultancy, supports the view that investment returns in retirement have an important role to play in meeting retirement ambitions. It suggests that only 10% of retirement income actually comes from contributions, with all the rest from investment returns, split 30% before retirement and a surprising 60% afterwards3. Even if we assume a lower – and perhaps more realistic – return assumption after retirement (5% rather than 7.8%), about 85% of pension income comes from investment returns, of which nearly 40% is earned after retirement. So investing in growth assets for longer is another ingredient for success (Figure 1).

1Arnott et al in ‘The Glidepath Illusion’ in Fundamentals, Research Affiliates, September 2012. 2 Medicalexpress.com. Improvements in life expectancy mean that retirees in the developed world can typically expect to have about 15 years in retirement, which could increase to over 20 years by the time current 40-year-olds retire. 3‘Where do defined contribution (DC) plan benefits come from? It’s not where you think’, Russell Investments, January 2008 and July 2012, and D. Don Ezra, ‘A Model of Pension Fund Growth’, Russell Investments, June 1989

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